The Australian Dollar and a Cheap Money Addiction

The Australian Dollar has surged to the highest levels this year on hopes of, you guessed it, ‘stimulus’, (from China, not Australia) and the prospect of higher domestic interest rates in the future (because of said stimulus). As the chart below shows, it’s now nudging up against the 200-day moving average (red line).

Australian Dollar Gaining Strength

In our view this is a counter-trend rally and will peter out soon enough. In late 2013, the AUD rallied from around 89 to 97 US cents before selling off to new lows. The same thing will likely happen again, although where this current rally ends we have no idea.

Reserve Bank of Australia chief Glenn Stevens will provide some clues this afternoon when he speaks at an investment conference in Hong Kong. After voicing concerns about the ‘stubbornly high‘ Australian dollar, in recent appearances Stevens has been more at ease with the currency’s strength.

We think this is because of the recent inflation scare, which showed prices rising faster than the RBA had expected. Much of this related to a weaker dollar which pushed up the price of import goods. Stevens and the RBA likely concluded that the dollar had to fall much more slowly to contain inflation, and so he stopped talking it down.

At around the same time the RBA moved away from an ‘easing bias‘ on interest rates, meaning they were happy to leave rates alone for an extended period.

Now, with the benefits of the RBA’s large 2011/12/13 interest rate cuts in full swing, many economists are calling for a new tightening cycle, with some expecting official rates to be 4.25% by the end of 2015.

We reckon this simply won’t happen. The only way it could happen is if China lost the plot completely and doubled down on its credit boom. That would ensure another terms of trade (ToT) boom for Australia and it would force the RBA to hike interest rates to remove the stimulus that flows through from such a boom.

But that’s simply not going to happen.

Right now we’re in the midst of a decline in the terms of trade. It would be very unusual for the RBA to enter a prolonged tightening cycle while the terms of trade were falling (see chart below). In fact, given the mining investment drop-off that Australia faces now and into next year, it would be a stupid thing to do.

If anything, you’ll see one or two rates hikes before the effects of tighter money bite. The Australian economy is addicted to cheap money. Higher interest rates now would quickly end the economic momentum.

From October 2011 to August 2012, the RBA cut the official cash rate from 4.75% to 2.5% – a historic low. That’s 225 basis points in cuts in just over 18 months. Coming from an already low base, that’s a significant amount of stimulus. In fact, it was too much.

With a lag of around 12 months, that monetary stimulus has been washing through the Australian economy for a while now, which is why all the interest rate sensitive sectors have been going gangbusters. We’ve had another housing boom, which is causing all sorts of social problems.

But it’s not sustainable growth. It’s short term, and once the stimulus wears off those sectors will be begging for more.

So don’t expect interest rates to rise too much, if at all, anytime soon. Glenn Stevens probably realises the RBA cut a little too much in bringing rates to 2.5%, and now he’s OK with a stronger dollar taking a little heat out of the economy. It buys him time.

PUBLISHER’S NOTE: If you can’t make it to Melbourne next week for our investing conference World War D, you can follow us on Twitter @DRAUS. We’ll be live tweeting the event to bring you as much of the action as we can. You’ll get insights on Richard Duncan, Jim Rickards, Satyajit Das and all our editors here at Port Phillip Publishing. It’s as close as you can get to the event LIVE.

Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market.
To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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